SCOTT REED: Diversifying portfolio balances risk, return

Recently, I wrote about my thoughts regarding the strengths of a diversified portfolio. It is not an earth-shattering concept – it’s basic Portfolio Construction 101. I’ve heard from several readers that they were interested in that column and really needed to make sure they were diversified. I realized I needed to write about how to diversify.
Over the years I’ve found many different opinions on what proper diversification looks like. It’s important to remember that the goal of a diversified portfolio is to decrease risk without significantly decreasing potential return. Keep your upside and make your ride as smooth as possible.
The first thing you must do to properly diversify away risk is to determine what risk you need to lower. I remember asking a potential client in 1999 if he thought he was well-diversified. He said he was, that his portfolio had 20 different stocks. The problem was he was trying to diversify away market risk, and all 20 stocks were technology stocks. Just three months after that conversation the technology sector crashed. The client lost about 70 percent of his market value because he didn’t have anything that could protect him against a crash in technology stocks. The client managed to be well-diversified against any one tech stock doing poorly, but not against the whole sector doing poorly.
There is a law of diminishing returns in diversification. The rule of thumb tells you that you start losing effectiveness fairly rapidly after about eight positions. So, my potential client from earlier could have diversified away most of his technology risk with just eight tech stocks. But if he wanted to diversify his total market risk, he would have to have eight different stocks from different asset classes. And if he wanted to be well-diversified in each asset class, he now has to have eight positions in each of eight asset classes. So now he is up to 64 positions in his diversified portfolio.
We’ve found it is extremely difficult to manage the overall portfolio, keep up with the research on 64 different securities and stay on top of it all. That’s why my firm spends its time working on the big picture of portfolio management. When we need to have a diversified portfolio in a specific asset class, we hire a money manager or a mutual fund to keep up with the individual securities for us. It is extremely hard to do everything in the investment process well. It’s helpful to find what you like to do most and hire out the rest of it.
There are four steps in this process: Determine your goals, pick your percent in the major asset classes (equities, fixed income and alternatives), pick your sub-classes (large-cap, small-cap, international, etc.) and pick your securities.
Make sure you are diversified in each one of those steps and you’ll have avoided a great many of the surprises that tend to come your way in the investment world.
Contact Scott Reed at (662) 823-4722 or sreed@hardyreed.com.